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What's the best time to invest in stocks? - Views on News from Equitymaster

What's the best time to invest in stocks?

Recently, we came across an interesting article on a financial portal called Daily Wealth. It dealt with the relation between the stock markets and the overall economy. In other words, it tried to figure out the compounded annual gains that stocks deliver at different growth rates for the economy.

GDP contraction is a good time

The results were quite interesting to say the least. Not that we did not expect it but it did re-affirm our faith in contrarian investing. And what did the results look like? Well, the study concluded that whenever the US economy contracted during a period stretching four quarters, stock markets have delivered their best returns over the next 12 months. And whenever the GDP has done well, stock markets have performed poorly the subsequent four quarters.

To be more specific, as per the study a contraction in US GDP has led to compounded returns of close to 19% over the next 12 months. Whereas in cases where GDP growth has been 6% over the preceding 4 quarters, stocks have returned a mere 4% over the next 12 months.

And what about a buy and hold strategy? We mean what if the investor would have held on to his stocks over the entire period under study? Well, in that case, his returns would have come a little over 7% compounded.

Thus, it is clear that investing at a time when the GDP has contracted in the last one year gives the best compounded returns over the next 12 months. This beats the buy and hold strategy, which a lot of long term investors recommend, by a long shot indeed.

The Indian scenario

This got us curious to know what would happen if a similar strategy is tried out in India? Well, we analysed the data going back 20 years and our results weren't any different.

Of course, since ours is a developing economy, our base case for the GDP not doing well cannot be a growth rate of less than zero. We will have to go with what our policymakers think as good and bad growth rates. And it is clear that in the current scenario anything below 6% is considered to be bad while anything above 7% is considered to be a good growth rate.

So, suppose at the start of every financial year you need to decide whether you should invest in stocks or not. And you try and look at the overall economic scenario in order to make your decision. Let's see what could have helped you earn the maximum returns.

Although we are going back only twenty years, the results aren't much different from what was experienced in the US.

If one would have invested at a time when GDP for the previous fiscal was below 6%, one would have got an average return of around 10% from the markets over the next 12 months. But if one would have invested at a time when the growth in the previous fiscal was more than 7%, his average returns would have been nearly flat. In other words, he wouldn't have gotten any returns from the market. A buy and hold strategy on the other hand would have yielded a CAGR of slightly over 7% during the period under consideration.

It should be noted that the results where economy grows below 7% are getting skewed due to one outlier year where the markets tanked around 45%. Excluding this, the average returns come in even higher at an impressive 19%.

Thus, there is a strong evidence that when an economy does not do well during a certain fiscal, stock markets do well over the next 12 months. And where the economy does well, performance of the stock market suffers over the course of the next 12 months.

Therefore next time you meet anyone who asks you to invest in stocks because the economy is doing quite well, you know what to do, right? Just ignore him.

How about returns over 3 years?

Of course, when it comes to stocks, one year may not be the most appropriate holding period. We thus tested our data against the returns that one would have got had he stayed invested for a period of three years after a bad economy year. The result wasn't any different with the stocks returning an average of 13% and 7% CAGR over a three year period when investments were made immediately after a sub 6% growth and above 7% growth respectively.

Conclusion

This is not to say that one should never invest in a good economy year. It's just that the odds of earning attractive returns increase when one invests immediately after a subpar performance from the economy.

Obviously, the most important question that comes to mind is should one invest in the current environment? Well, the economy is projected to grow by 5% in the current financial year which is below its potential. Thus, there is a good chance that making investments now could yield good returns in the short to medium term.

Rahul Shah (Research Analyst), Managing Editor, Microcap Millionaires has led the team from the front in developing some of our most stringent and rewarding research processes. As per his own admission, the turning point in Rahul's life as a financial analyst came a few years back when he got introduced to the works of Warren Buffett and Charlie Munger. From Buffett, he understood the value of investing in good quality business with powerful moats and strong management teams. Charlie Munger on the other hand inspired him to be a lifelong learner and use mental models in order to arrive at the crux of matters across most disciplines. Rahul firmly believes that in order to be successful at investing, you have to do the big things right and possess a great temperament and a contrarian streak.

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